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The rate of discovery has been exponential.
As for other human endeavours we seem to be regressing. Where are the modern day Michaelangelos, Da Vincis, Van Goghs, Picassos or Mozarts? Given these divergent paths, it's hardly surprising that many disciplines seek an association with science. Social science, business science, building science, sports science - science is invading everything we do. What about investment?
Many argue that investment is an art, despise the efforts of quants to force it into a set of mathematical and statistical equations.
Warren Buffett, arguably the most successful investor of all time, had this to say on modern portfolio theory (MPT): "Diversification is for fools who need to protect themselves from their own poor decisions." Can the risk management fraternity withstand such a high profile attack? Is there a place for MPT, or will Markowitz's Nobel Prize-winning work forever languish in the pages of financial textbooks of no practical use to portfolio managers?
Risk and MPT are often misunderstood.
Buffett's comment is not at odds with Markowitz's theories. The key is that risk cannot be considered in isolation.
Risk and skill are two sides of the same coin. Risk means uncertainty - the uncertainty that the expected outcome will not materialise. Skill in investment terms is forecasting ability, the ability to narrow uncertainty.
We can better understand the skill/risk relationship by considering the theoretical extremes of the skill spectrum.
If you have perfect skill - the ability to forecast the future - then risk is nullified.
If you know with certainty what stock returns over the next year will be then there's no need to diversify - just buy the best stock.
On the other end of the spectrum (zero skill), you have no idea how stocks will perform and need to diversify. How much should you diversify? The capital asset pricing model (CAPM) proves mathematically that under this scenario you should diversify fully - hold the market index. In fact, a linear combination of cash and the market depending on your risk appetite. An aggressive investor will hold a leveraged market position while a conservative investor will invest only a portion of his capital in the market, keeping the remainder in cash.
MPT has been tainted by a separate, unrelated piece of academic theory: the efficient market hypothesis (EMH).
Under EMH, all price-relevant information is immediately reflected in prices, and since the arrival of new information is unforecastable, stock returns themselves are unforecastable. The interaction between skill and risk is therefore redundant.
All investors fall into the zero skill category and should diversify to the maximum extent possible.
The EMH occupied a central role in academic research for much of the second half of the 20th century. Not surprisingly, academic research and commercial security analysis parted ways at this point.
However, in the past two decades serious cracks have appeared in the EMH, and academics are actively prying open those cracks.
Behavioural Finance has proved a powerful crowbar for the task. For the first time since the birth of MPT, academics and active managers are not cast against each other. In fact many of the academics are migrating into active management, setting up their own asset management firms or hedge funds.
There is now considerable evidence that at least cross-sectional returns are predictable.
By cross section we mean that we can predict which stocks will do better than others, yet it is difficult (but not impossible) to predict the overall direction of the market, especially in the near term.
So, once we reject the EMH, the question becomes how much should you diversify? Even Warren Buffett holds more than one stock. Why doesn't he invest all his capital in his best idea?
Because even the best investors have the humility to accept that forecasting stock returns is extremely difficult. Also, all investments have a limited horizon.
You may be proven correct in the long run, but insolvent in the short run.
Before we answer the question of "how much", let's consider the two dimensions of diversification. We all know the first: "Don't place all your eggs in one basket", so the more stocks we hold, the more we diversify risk. The second is also generally accepted wisdom:
"Invest for the long term." The longer we hold those stocks, the lower the risk.
Let's forget the risk management jargon for a moment. We replace _, _, _, TE, IC, IR, kurtosis, skewness and all the other real world complications with a simple case of heads or tails - the insight is the same.
Suppose that instead of picking stocks, we hold portfolios of coins. The monthly returns are determined by a flip of each coin. Heads is a positive outcome (100% return) while tails is negative (-100% return).
In an EMH world, skill is irrelevant since all coins are unbiased, the odds are 50/50 and the outcome of our "investment" is left purely to chance.
If we choose not to diversify at all, we bet all our capital on one coin flip. We either double our capital or lose everything.
Only the brave or the stupid would accept that gambit.
Facing these odds an investor would diversify: split his/her capital between as many coin flips as possible. By flipping many coins simultaneously (holding a fully diversified portfolio) and playing for a long time (invest for the long term), the actual outcome will soon converge to the expected outcome. Risk is diversified away.
Suppose now that the coins are not fair. Imperceptible to the untrained eye, some of the coins are biased towards heads while others are biased towards tails, by varying degrees.
The best coins favour heads 60% of the time, while the worst favour tails 60% of the time. Skill in this simulation would be the ability to differentiate between heads-biased and tails-biased coins. The better you are at doing so the fewer coins you need.
But even if you have perfect skill you identify with certainty a 60% heads biased coin, there's still a 40% risk of insolvency.
So how many coins should you hold?
It depends on your risk tolerance, and how much can you afford to lose in the short term.
If you hold five coins and assume that each additional coin you add is not quite as good as the previous one (otherwise you'd have chosen it initially), the insolvency risk may look something like this:
0,40 * 0,41 * 0,42 * 0,43 * 0,44 = 1,3% - a lot better than 30%. The portfolio expected heads ratio is now: Average (60%, 59%, 58%, 57%, 56%) = 58%, slightly lower than the single coin portfolio case of 60%.
Here we see the familiar risk/return trade-off: additional coins reduce risk but since they're incrementally less favourably biased, return is also diluted.
So Warren Buffett's comment is entirely consistent with MPT. If you have skill and patience your investments should be concentrated. If either is lacking then you should consider another piece of advice from the great Omaha value investor: "...70% of investors would be better off in an index fund".
Investment is part art and part science.
The delineation is not as clear-cut as "risk is science, return is art". The best "artists" - portfolio managers who have no formal risk management process or portfolio construction algorithms - have an instinctive feel for risk management and can construct near optimal portfolios despite their lack of systems.
The "scientists" - the active quant managers who utilise statistics, mathematics and software tools throughout their process - still rely on their creative side in conceptualising their models and interpreting the output. The client's best interests are served when the artists and the scientists can work together.
Art and science are not mutually exclusive: Da Vinci excelled at both.
Though better known as an artist he was also an accomplished inventor and scientist - the original Renaissance man.
Da Vinci would have made a brilliant investor.
Grant Irvine-Smith
Grant Irvine-Smith is head of quantitative equity products at Investec Asset Management.
He runs a proprietary stock selection model, used to construct enhanced index and active quant portfolios for the institutional market. A market neutral fund is currently in test phase. He also manages the Investec Index Fund Unit Trust.
He's been with Investec five years and worked in the engineering field for four years prior to that. He holds a BSc Eng (Civil) from WITS, an MBA from UCT (Gold medallist) and is a CFA charter-holder.
